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WHY the FISCAL MULTIPLIER IS ROUGHLY ZERO* Fiscal Policy Doesn’T Work When the Central Bank Stabilises Aggregate Demand, Says Scott Sumner

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WHY the FISCAL MULTIPLIER IS ROUGHLY ZERO* Fiscal Policy Doesn’T Work When the Central Bank Stabilises Aggregate Demand, Says Scott Sumner FEATURE WHY THE FISCAL MULTIPLIER IS ROUGHLY ZERO* Fiscal policy doesn’t work when the central bank stabilises aggregate demand, says Scott Sumner any observers have been perplexed somewhere.3 If the government borrows funds by the slow recovery from the to boost spending, then interest rates might rise, 2008 recession. In the United which would crowd out private investment States, Congress passed a nearly expenditures on consumer durables, new homes, M$800 billion stimulus in early 2009—yet growth and business ventures. Although crowding out remained sluggish. More recently, a shift towards can reduce the effectiveness of fiscal stimulus, fiscal austerity does not seem to have noticeably Keynesians correctly note that when interest rates slowed the rate of economic growth.1 This seems are zero, it is unlikely that additional government to go against the textbook Keynesian model, borrowing will be fully offset by declining private which says fiscal stimulus has a multiplier effect investment, especially if the central bank holds on GDP; however, we shouldn’t be surprised that rates close to zero.4 fiscal policy seems less effective than anticipated. Why has the effect of fiscal stimulus been so As we’ll see, fiscal policy ineffectiveness is one meagre in recent years? After all, interest rates by-product of modern central banking, with its in the United States have been close to zero since focus on inflation targeting. the end of 2008. The most likely explanation is The traditional ‘multiplier’ approach to monetary offset, a concept built into modern central fiscal policy is based on John Maynard Keynes’ bank policy but poorly understood. We can visualise observation that consumers usually spend a large monetary offset with the Keynesian aggregate share of any increase in their income.2 Government supply and demand diagram used in introductory spending programs and tax cuts put dollars economics textbooks. If fiscal directly into the pockets of consumers, regardless stimulus works, it’s by shifting the of how effective they are on a cost-benefit basis. aggregate demand (AD) curve to If consumers spend 80% of their extra take-home the right. This tends to raise both pay on goods and services, then other workers prices and output as the economy and firms will earn additional income. A portion moves from point A to point B, of that income boost will also be spent, leading although in the very long run, only to a multiplier effect, whereby total aggregate prices are affected. demand rises by more than the initial government stimulus. The multiplier represents the ratio of the total increase in spending to the initial increase Scott Sumner has taught economics at Bentley University in government spending. since 1982. He also runs a popular blog on monetary policy, Conservative critics of fiscal stimulus often ‘The Money Illusion.’ point out that the extra dollars must come from * This essay was originally published in September 2013 by the Mercatus Center at George Mason University. It has been reproduced here with the permission of Mercatus and the author. POLICY • Vol. 30 No. 2 • Winter 2014 3 WHY THE FISCAL MULTIPLIER IS ROUGHLY ZERO If monetary offset was well understood by the 1990s, why was there so much support for fiscal stimulus in the recent recession? It seems that many economists wrongly assumed that the normal monetary offset model no longer held, due to three misconceptions: 1. In early 2009, many economists wrongly assumed that the Fed was out of ammunition, leaving monetary policy adrift—or passive.7 2. Some economists have told me that the Fed would never attempt to sabotage fiscal stimulus because the Fed also wanted to see a robust recovery. 3. Fed officials like Ben Bernanke occasionally spoke out against fiscal austerity, making monetary offset seem even less likely.8 Now let’s assume that the central bank is targeting inflation at 2%. If fiscal stimulus shifts By now we know that central banks are not the AD curve to the right, then prices will tend out of policy options when rates fall to zero.9 And, to rise. The central bank then must adopt a more in a sense, this never should have been in doubt. contractionary monetary policy to prevent inflation When Japanese interest rates hit zero in the from exceeding their 2% target. The contractionary late 1990s, Ben Bernanke (then an academic) monetary policy shifts AD back to the left, dismissed arguments that policy is ineffective at offsetting the effect of the fiscal stimulus. This is the zero bound.10 So did Milton Friedman.11 The called monetary offset. best-selling monetary economics textbook of By the 1990s this process was pretty well 2010, written by former Fed official Frederic understood, which is why even many of the Mishkin, noted that monetary policy remains so-called New Keynesian economists began to ‘highly effective’ when short-term rates fall close lose interest in fiscal policy as a stabilisation tool.5 to zero.12 We’ve recently seen the Bank of Japan Instead, the focus shifted to central bank policy, engineer a sharp depreciation of the yen, despite and elaborate rules were devised to assist the near zero interest rates. This contradicts Keynesian central bank in steering the economy towards low ‘liquidity trap’ models, which suggest that central inflation and stable growth. Perhaps the most banks are unable to depreciate their currencies famous was the Taylor Rule, which called for central once short-term rates fall to zero. It’s safe to say banks to adjust interest rates to keep inflation near that the ‘out of ammunition’ view of monetary 2% and output close to potential output.6 ineffectiveness has been thoroughly discredited. If the central bank is steering the economy The other two objections to monetary offset are or, more precisely, nominal aggregates, such as harder to dismiss. The Fed has been disappointed inflation and nominal GDP, then fiscal policy by the pace of recovery and wishes that aggregate would be unable to impact aggregate demand. As demand had risen at a faster pace over the past five an analogy, imagine a child attempting to turn the years. This remains the central reason why most steering wheel of a car. The parent might respond Keynesians continue to favour fiscal stimulus. by gripping the wheel even tighter, offsetting the But on closer inspection, it seems quite likely that push of the child. Even though the child’s actions the Fed has been sabotaging fiscal stimulus (and would initially change the direction of the car, offsetting recent austerity), perhaps without even ceteris paribus, the parent will push back with realising it. equal force and correct this turn to keep the car on To see why monetary offset continues to the road. be operative, consider the sorts of statements 4 POLICY • Vol. 30 No. 2 • Winter 2014 SCOTT SUMNER continually made by Fed officials. We never hear will ask, ‘Surely you don’t think Ben Bernanke them explicitly say they’ll sabotage fiscal stimulus, would offset fiscal stimulus?’ But this isn’t really but we do hear them say they will calibrate the asking the right question. The question that level of monetary stimulus to the health of the should be asked is, ‘Will Ben Bernanke do what is economy. For instance, the recent Evans Rule necessary to keep nominal spending on a path commits the Fed to hold interest rates close to consistent with low inflation and stable growth?’ zero until unemployment falls to 6.5%, or core which is roughly the Fed’s mandate. (Actually, inflation rises above 2.5%.13 Because fiscal stimulus the mandate speaks of inflation and employment, would presumably make this happen sooner, but jobs and growth are closely linked.) The real it would also, ipso facto, cause the Fed to raise question is whether the central bank will do its job, interest rates sooner than otherwise. Thus, fiscal regardless of what is happening on the fiscal front. stimulus would lead to tighter money over time. Of course, that doesn’t necessarily fully offset The question that should be asked is, the effects of fiscal stimulus, but it’s an explicit ‘Will Ben Bernanke do what is necessary to admission by the Fed that if the fiscal authorities keep nominal spending on a path consistent do more, they will do less. An even better example occurred in late 2012, with low inflation and stable growth? when the Fed took several steps to make monetary policy more expansionary, including adoption of When viewed this way, estimates of fiscal the Evans Rule and additional quantitative easing multipliers become little more than forecasts of (QE), or injections of bank reserves through bond central bank incompetence. If the Fed is doing purchases. Why did the Fed take such bold steps? its job, then it will offset fiscal policy shocks and Some Fed officials pointed to the looming fiscal keep nominal spending growing at the desired cliff, which was widely expected to lead to steep level. Bernanke would deny engaging in explicit tax increases. A possible spending sequester was monetary offset, as the term seems to imply also lurking in the background. Fed officials were something close to sabotage. But what if he were determined to do enough stimulus to keep the asked, ‘Mr Bernanke, will the Fed do what it can recovery going, despite headwinds from both to prevent fiscal austerity from leading to mass fiscal austerity and recession in Europe. unemployment?’ Would he answer ‘no’? And so far it looks like they’ve succeeded. Another debate revolves around the Fed’s Job growth during the first six months of 2013 willingness to engage in unconventional monetary was running at more than 200,000 new jobs stimulus.
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